Finally, Tax Reform That Romney and Obama Can Agree On

Throughout the 2012 election season, tax reform has been a key topic of debate. During the Republican primaries, candidates proposed pro-growth models that featured flat taxes, capital gains tax cuts, a broader tax base, and a simpler tax code. President Obama has instead focused on income equality reforms that include higher taxes for the rich, lower taxes for the poor and middle class, and the elimination of corporate and high income tax loopholes. Due to partisan politics in Congress, it seems unlikely that the next president will be able to enact his respective tax reform effectively. However, consider a broad-base tax plan that could satisfy both Republicans and Democrats in Congress.

A national consumption tax, according to a growing consensus among economists, could foster growth and reduce inequality by encouraging savings and reducing wasteful consumption. If implemented, this tax reform could help the U.S. economy recover and experience greater prosperity in the future.

A consumption tax is a tax on all expenditures besides savings. To clarify the meaning of consumption, use the equation: Income – Savings = Consumption. The problem with the current income tax is that it punishes both consumption and savings. Under a consumption tax, however, all savings would be exempt from taxation. Over the last 30 years, the U.S. personal savings rate has declined significantly from 9 percent in the early 1980s to below 2 percent in 2007. According to the UCLA Department of Economics and Boston University School of Management, this decline has led to increased U.S. dependency on foreign investment and a reduction in national capital stock. By protecting savings through a national consumption tax, consumers would save more of their income, thereby boosting domestic investment, capital formation, labor productivity, and ultimately economic growth.

Still, many economists warn that a consumption tax would be regressive because poor Americans use a majority of their income for consumption. To address this concern, Robert Frank, a Cornell economics professor, proposes using standard deduction and progressive marginal tax methods. In a 2008 article in Democracy: A Journal of Ideas, Frank explains his proposal by considering a family whose annual income and savings are $50,000 and $5,000 respectively. Under Professor Frank’s progressive consumption tax system, this household would receive a $30,000 deduction for necessary consumption products (food, rent, etc.). Thus, their taxable income would be $50,000 (Income) – $5,000 (Savings) – $30,000 (Deduction) = $15,000 (Taxable Consumption Expenses). Under a 10 percent tax rate (since marginal tax rates on taxable consumption would start low), they would pay $1,500 in taxes which is about half what they pay under the current tax code. To make the tax reform revenue neutral (meaning it generates the same revenue compared to the current tax code), marginal consumption tax rates would be applied on a progressive scale.

Some economists also worry that a consumption tax would reduce consumer welfare because it lowers consumption. However, when examined further, one realizes that consumer welfare is truly a relative concept. For example, consider hypothetical friends, Bill and Mary. Bill is car shopping and has narrowed it down to two properly functioning vehicles: a $100,000 Mercedes-Benz or a $20,000 Honda Accord. Because Mary recently bought a $100,000 Cadillac, Bill chooses the Mercedes-Benz in order to maintain his relative economic status in comparison to Mary. This type of behavior fuels the competition for luxury goods which leads to wasteful consumption and puts many individuals and families into debt. In a 2011 New York Times article, Professor Frank explains that this behavior also exacerbates economic inequality because it influences the wealthiest to increase the “frames of reference” for being rich, while the U.S. median household income continues to stagnate. He later goes on to say that implementing a progressive consumption tax system would solve these problems because wealthy individuals would “save more and spend less on luxuries, leading to greater investment and economic growth.” This new behavior would influence the lower classes to do the same which decreases wasteful consumption and increases their wealth in the long term.

Because the United States has a consumer-driven economy, the progressive consumption tax should be implemented on a gradual scale to slowly shift spending from consumption to investment, causing productivity and incomes to rise faster. And, according to Frank, the progressive consumption tax could allow for more effective tax cuts during recessions, because a temporary consumption tax cut would induce consumers to “spend more right away.” This differs from an income tax cut because “consumers who fear losing their jobs in a recession are often reluctant to spend temporary income tax refunds.”

The progressive consumption tax offers an innovative solution to both growth and inequality problems in the United States economy. Politicians from the left and right can find common ground under this proposal; thus they should be able to implement it without biased based lethargy. Most importantly, the United States economy needs to maintain its international competitiveness and high consumer welfare. The progressive consumption tax would not only achieve these goals but spur American economic prosperity for years to come.